1.How can a change in the terms of trade affect the balance of trade ? (25)
2. How can a change in the balance of trade affect the terms of trade ?
The terms of trade is the index of export prices divided by index of import prices (*100)
An improvement in the terms of trade mean that export prices are increasing faster than import price. Therefore there will be a fall in exports and an increase in quantity of imports. Therefore, it is likely that with lower exports the current account deficit (+ trade deficit) will get worse, i.e. bigger deficit
However, it relies on the Marshall-Lerner Condition. If the Marshall-Lerner condition is satisfied then an improvement in the terms of trade will worsen the current account.
The Marshall Lerner condition states that if demand for exports and imports is relatively elastic PED x + PED m >1 then an increase in terms of trade will worsen the current account (balance of trade)
Sometimes elasticity of demand varies over time. In the short term demand is often inelastic, in the longer term demand becomes more elastic. Therefore, we can often see a J Curve effect, where an improvement in terms of trade worsens current account in short term but improves in long term.
If a country experiences a deterioration in the balance of trade (value of imports increase faster than value of exports) then if may impact upon the terms of trade.
A deterioration in the balance of trade means a country is importing more than exporting. Therefore more currency will be leaving a country. This would mean an increase in supply of pound sterling and lower demand. Therefore, it is likely to cause a devaluation. This would mean cheaper exports and more expensive imports. We say this would be a deterioration in the terms of trade.
Example, The US has a large trade deficit, and this has been contributing to a devaluation in the dollar. Therefore deteriorating the terms of trade.
However, other factors may be affecting the terms of trade. For example, it depends on whether there is a strong inflow on other aspects of the balance of payments like the trade in services of financial account (capital flows)
Also other factors can affect exchange rates like confidence, speculation and relative interest rates. Therefore, in the short term a change in the balance of trade doesn’t necessarily affect the terms of trade although in the long term it probably will.